Knight Capital Group: Buy Or Sell?

There has been a lot of controversy surrounding Knight Capital Group, Inc. (NYSE:KCG) lately, with many views being expressed here on this website. This brings up one simple matter; should we buy, sell, or hold this stock?

I have taken the time these past couple of days to see what the buzz is all about and whether we should get in, get out, or sit tight. There is no doubt this stock has been very volatile considering recent news, but has a turnaround finally come or has it crashed completely? What I will attempt to explain is whether its run is truly up, or if this is just a bump in the road.

The Buzz

Knight Capital Group is a global financial services firm that provides access to the capital markets across multiple asset classes to a network of clients, including buy- and sell-side firms and corporations. The company operates in four segments: Market Making, Institutional Sales and Trading, Electronic Execution Services, and Corporate and Other.

KCG conducts the vast majority of its market making activity as principal through the use of automated quantitative models. When acting as principal, KCG commits its own capital and derives revenues from the difference between the amount paid when securities are bought and the amount received when the securities are sold. The company competes with domestic and international broker-dealers, exchanges, ATSs (alternative trading systems), crossing networks, ECNs (electronic communications networks) and dark liquidity pools.

The current market price is $2.76 with a one-year analyst price target of $4.48. This represents a 62.32% upside potential, but is likely to be revised. Based on a forward price-to-book multiple of 0.3X, well below peers, I forecast a likely one-year price target of $3.50, a 26.81% upside potential.

KCG's net margin has been higher than its Industry average for each of the past five years. Also, KCG's current forward PEG of 0.5 represents a 48% discount to its Inv Bank & Brokerage Svcs Industry average and a trailing P/E of 3.3 representing an 83% discount to its peers.

The Good and The Bad

Knight capital enjoyed 22% revenue growth in 2011, but is expected to have a decline of 8% for fiscal year 2012. This number is expected to reverse to 8% increase in 2013. KCG continues to maintain one of the highest ranks in shares traded across different securities. There is no doubt the recent $400M loss has impacted the company severely, but there are underlying benefits to garner. The company was able to get a buffer to save itself and its clients. It was able to "start" rebuilding without getting the taxpayers involved.

"The big take away for investors is that a computerized trading program was at the center of a glitch so big that Knight didn't have enough capital to take the losses it created. Look how easily the system can blow up without human intervention. That's scary," says Dan Seiver a professor at San Diego State University.

Given its most recent slip-ups, the company has taken extreme measures to turn its situation around in just a few days and given its lifeline have strong expectations it will do just that. For fiscal year 2013, analysts estimate that KCG's earnings per share will grow by 48% to $1.35, which would take a substantial amount of pressure off the company and help restore confidence, although it still carries its 3-star S&P rating (same as Google, Mastercard, and Chipotle).

The August 1 disruption to routing NYSE-listed securities cost the company $440 million in pretax losses and hurt its reputation in the market. KCG had a market leading position in trading cash equities. Both institutions and retail investors trade through KCG's trading platform, but may be reluctant to do so going forward. The loss is just the beginning of an onslaught of shareholder lawsuits and regulatory penalties that may follow. The company is also facing an increased amount of downgrades, which instills fears in investors.

The company showed how automated investing can be extremely risky and the fears from Capitol Hill taking action are severely high. The company finds itself in a similar position as Bear Stearns was once in.

Conclusion

In 8-K filing, KCG says it has entered into a securities purchase agreement, by and among company and investors signatory thereto (the investors) pursuant to which the investors agreed to purchase an aggregate of $400M of 2% convertible preferred stock of the company. Preferred Stock will be convertible into approximately 267 million shares of common stock. This was a smart move that saved the company well, and will only help it in the future.

This "catastrophe" is supposed to show just how fragile the financial industry really is, but truthfully the finance industry not only has fewer missteps than the rest of corporate America, but sometimes the missteps of the industry can cause good. This sort of failure allows the company to restructure and reorganize. Unfortunately the mistake almost cost the company its life, but just like with anything it is not the mistake, but what you do after the mistake that counts. This will allow the company to update and revamp the way it conducts business, and if it can pull itself out of this rut, I believe the company can see substantial gains in the future.

Sure this may be a risky bet, but I do feel that the reward is greater than the risk in this case. Remember sometimes failure does not mean "complete failure." Let's look at examples of this where companies were saved by investors: Bank of America Corporation (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), etc. These are just a handful of examples where sometimes the system crashing can bring new growth. Also, once all of the preferred shares are diluted into the common shares, the book value of the company will still be $4 a share, 33% higher than the current price. I feel at the current price, the company is a great buy for long-term growth.

Disclosure: I am long KCG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.